Depression of 1920–21

The Depression of 1920–21 in the United States was brief relative to the Great Depression of a decade later, but it included a remarkably sharp price deflation.[1]

In this depression prevailed the old-fashioned view that government should keep taxation and spending low and reduce the public debt. The economy recovered swiftly, especially when compared with the Great Depression.[2]

Contents

Crisis

The years preceding 1920 were characterized by a massive increase in the supply of money via the banking system, with reserve requirements having been halved by the Federal Reserve Act of 1913 and then with considerable credit expansion by the banks themselves.

Total bank deposits more than doubled between January 1914, when the Fed opened its doors, and January 1920. The Fed also kept its discount rate (the rate at which it lends directly to banks) low throughout the First World War (1914–1918) and for a brief period thereafter. The Fed began to tighten its stance in late 1919. Once credit began to tighten, market actors suddenly began to realize that the structure of production had to be rearranged and that lines of production dependent on easy credit had been erroneously begun and needed to be liquidated.[2]

At the conclusion of World War I, U.S. officials found themselves in a bleak position. The federal debt had exploded because of wartime expenditures, and annual consumer price inflation rates had jumped well above 20 percent by the end of the war.

The unemployment rate peaked at 11.7 percent in 1921. But it had dropped to 6.7 percent by the following year, and was down to 2.4 percent by 1923.

To restore fiscal and price sanity, the authorities implemented what might seem today as incredibly "merciless" policies. From FY 1919 to 1920, federal spending was slashed from $18.5 billion to $6.4 billion—a 65 percent reduction in one year. The budget was pushed down the next two years as well, to $3.3 billion in FY 1922.

On the monetary side, the New York Fed raised its discount rate to a record high 7 percent by June 1920. It might seem that this nominal rate was actually "looser" than the 1.5 percent discount rate charged in 1931 because of the changes in inflation rates. But on the contrary, the price deflation of the 1920–1921 depression was more severe. From its peak in June 1920 the Consumer Price Index fell 15.8 percent over the next 12 months. In contrast, year-over-year price deflation never even reached 11 percent at any point during the Great Depression. Comparing nominal interest rates or "real" (inflation-adjusted) interest rates, the Fed was very "tight" during the 1920–1921 depression and very "loose" during the onset of the Great Depression.

After the depression the United States proceeded to enjoy the "Roaring Twenties," arguably the most prosperous decade in the country’s history. Some of this prosperity was illusory—itself the result of subsequent Fed inflation—but nonetheless the 1920–1921 depression "purged the rottenness out of the system" and provided a solid framework for sustainable growth.

Things turned out decidedly differently in the 1930s. Despite the easy fiscal and monetary policies of the Hoover administration and the Federal Reserve, the unemployment rate kept going higher and higher, averaging an astounding 25 percent in 1933. After the "great contraction" the U.S. proceeded to stagnate in the Great Depression of the 1930s, possible the least prosperous decade in the country’s history.[3]

Ponzi scheme

This period also featured the most famous scam in American history - the Ponzi Scheme of 1920. In this scam, Charles Ponzi, an immigrant to the United States, promised investors 50 percent interest for ninety days (an amazing 200 percent annual rate of interest, even ignoring compounding!). And, for a while, he actually was paying 50 percent interest for ninety days.

People started lining-up to turn their money over to him, altogether 40,000 did, investing an average of $300 each. How could he pay such a spectacular rate of interest?

Once he got his scheme going, he was able to pay interest to old investors from the money provided by new investors. Very little money was actually invested in productive assets. But, the supply of suckers—while large—is limited, and soon he was forced into default.

When he was arrested, he was found to have had a criminal record, forgery, to be exact. Then, after serving some time in jail, he returned to his native Italy and got a job in the Italian airlines.[4]